How Did Bernanke Scare the Markets?

On Wednesday Ben Bernanke appeared before the Joint Economic Committee of the US Congress to give his semi-annual report to Congress on the Economic Outlook. The S&P 500 opened the day about 1% higher than at Tuesday’s close, but by early afternoon had already given back all their gains, before closing 1% lower than the day before, an interday swing of 2%, pretty clearly caused by Bernanke’s testimony. The Nikkei average fell by 7%. Bernanke announced no major change in monetary policy, but he did hint that the FOMC was considering scaling back its asset purchases “in light of incoming information.” So what was it that Bernanke said that was so scary?

Let’s have a look.

Bernanke began with a summary of economic conditions, giving himself two cheers for recent improvements in the job market. He continued by explaining how, despite some minimal and painfully slow improvements, the job market remains in bad shape:

Despite this improvement, the job market remains weak overall: The unemployment rate is still well above its longer-run normal level, rates of long-term unemployment are historically high, and the labor force participation rate has continued to move down. Moreover, nearly 8 million people are working part time even though they would prefer full-time work. High rates of unemployment and underemployment are extraordinarily costly: Not only do they impose hardships on the affected individuals and their families, they also damage the productive potential of the economy as a whole by eroding workers’ skills and–particularly relevant during this commencement season–by preventing many young people from gaining workplace skills and experience in the first place. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.

Bernanke then shifted to the inflation situation:

Consumer price inflation has been low. The price index for personal consumption expenditures rose only 1 percent over the 12 months ending in March, down from about 2-1/4 percent during the previous 12 months. This slow rate of inflation partly reflects recent declines in consumer energy prices, but price inflation for other consumer goods and services has also been subdued. Nevertheless, measures of longer-term inflation expectations have remained stable and continue to run in the narrow ranges seen over the past several years. Over the next few years, inflation appears likely to run at or below the 2 percent rate that the Federal Open Market Committee (FOMC) judges to be most consistent with the Federal Reserve’s statutory mandate to foster maximum employment and stable prices.

In other words, the job market, despite minimal improvements, is a disaster, and inflation is below target, and inflation expectations “continue to in the narrow ranges seen over the past several years.” What does that mean? It means that since the financial crisis of 2008, inflation expectations have consistently remained at their lowest levels in a half century. Why is any increase in inflation expectations above today’s abnormally low levels unacceptable? Bernanke then says that inflation appears likely to run at or below the 2% rate that FOMC believes is most consistent with the Fed’s mandate to foster maximum employment and stable prices. Actually it appears likely that inflation is likely to run below the 2% rate, perhaps by 50 to 100 basis points. For Bernanke to disguise the likelihood that inflation will persistently fail to reach the Fed’s own nominal 2% target, by artfully saying that inflation is likely to run “at or below” the 2% target, is a deliberate deception. Thus, although he is unwilling to say so explicitly, Bernanke makes it clear that he and the FOMC are expecting, whether happily or not is irrelevant, inflation to continue indefinitely at less than the 2% annual target, and will do nothing to increase it.

You get the picture? The job market, five and a half years after the economy started its downturn, is in a shambles. Inflation is running well below the nominal 2% target, and is expected to remain there for as far as the eye can see. And what is the FOMC preoccupied with? Winding down its asset purchases “in light of incoming information.” The incoming information is clearly saying – no it’s shouting – that the asset purchases ought to be stepped up, not wound down. Does Bernanke believe that, under the current circumstances, an increased rate of inflation would not promote a faster recovery in the job market? If so, on the basis of what economic theory has he arrived at that belief? With inflation persistently below the Fed’s own target, he owes Congress and the American people an explanation of why he believes that faster inflation would not hasten the recovery in employment, and why he and the FOMC are not manifestly in violation of their mandate to promote maximum employment consistent with price stability. But he is obviously unwilling or unable to provide one.

Why did Bernanke scare the markets? Well, maybe, just maybe, it was because his testimony was so obviously incoherent.

Bernanke´s lack of leadership qualities allows the FOMC to become like the Roman Senate. I don´t recall such a cacophany during Greenspan´ s tenure.. Much easier to decipher mutterings than guess who´s winning the ‘tug of war’!

David,
Any comment of the latest rally in the face of the inflation disappointments you cite? Perhaps if the stock market is not worried, then the Fed should not be. Might the Fed might reach this conclusion based on Market Monetarism?

Also, a post on which inefficiency currently segments markets would be useful. In other words, if risk asset prices are flying in the face of the credit deadlock, then arbitrage is clearly not working. For instance, if I am pessimistic, I can write a long term put on the S&P500 and hedge it by buying a cheaper put on Treasuries. What prevents this arbitrage? Preferred habitat? Lack of credit for arbitrageurs? Agency effects?

An alternative explanation is the Fed is manipulating real bond yields through QE, mostly via agency effects (i.e. traders frontrun their clearly-communicated purchases). This would explain both the rally in risk assets and the presence of negative bond yields. It is consistent with the presence of arbitrage across markets. It does require, however, that arbitrage not be possible across time horizons (due, again, to agency effects).

The usefulness of economics lies in forcing us to lay bare our assumptions. If there is an implicit assumption of market failure, it would be interesting to discuss it.

Let’s see, in a democracy policy-making bodies are transparent and accountable. Our most important macroeconomic policy-making body is the Fed.

Let’s see—what does the Fed plan to do? I don’t know. They say they have a 2 percent inflation target, but I thought it had been upped to 2.25 percent, or something like that, but now Bernanke says the Fed probably won’t hit 2 percent. Clear?

Our labor force is shrinking for want of work….

And who is the FOMC board accountable to? Can I vote them out of office? Without checking Wikipedia, how do these guys get to sit on the FOMC? Does anybody sit on the FOMC board from the the construction industry, or labor, or manufacturing, or agriculture?

You know, for a long time I thought Fed independence was a good thing.

But, I was wrong, and wrong to my own better judgement, and wrong in front of my own principles.

Democracy. A cruddy way to run a nation, until you try any other way. It always comes back to that.

The Fed is not a democratic institution. It is cloistered, secluded, inbred, impervious, apart.

Have the US President appoint the Fed chief, coterminous to his own stay in office.

Then, would the Fed loosen the monetary noose around the economy’s neck?

Marcus, We’re so much alike. Actually, at least on a personal level, I like the fact that Bernanke is not as controlling as Greenspan. Maybe he doesn’t have the right stuff for the job. That would be OK, but he doesn’t have to sound like an idiot.

Julian, Bad as I think Bernanke is sometimes, he’s got a long way to go before he gets play in the same league as the Bank of France. Let’s hope he doesn’t make it that far.

Tom, My basic thought is that with interest paid on reserves, the demand for reserves is perfectly elastic, so we can model the price level as being determined by the stock of currency and the demand for currency. I guess that means monetary policy is really determined by the drug dealers not the Fed. Who knew?

Diego, It may be that we are in some sort of transitional period. Real interest rates are rising rapidly; the yield on the 10-year TIPS is almost up to zero! That seems to suggest that expectations are becoming more optimistic even without any increase in inflation expectations. This may be a spontaneous recovery for which no one gets to claim credit.

Benjamin, Think about it. The spectacular, but short-lived, recovery of 1933, was the product of a single individual: FDR. The Great Depression could have been over in a year or two at the most. Nice to dream about. Unfortunately, he messed it all up with his NIRA, and then came 1937. So democratic monetary policy has a big upside and a big downside. Which is better? I depends.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.